Exemplary embodiments of the present invention are directed to credit default swap contracts (CDS). Credit default swap contracts involve one party (referred to as the protection buyer) buying protection from another party (referred to as the protection seller) in case of a credit event, such as the issuer of the debt instrument declaring bankruptcy, failing to pay an amount due on a debt instrument or restructuring a debt instrument. When a credit event occurs, the contract requires the protection seller to make a payment to the protection buyer in the course of physical or cash settlement of the credit default swap.
Physical settlement involves a protection buyer delivering one or more debt instruments to the protection seller, and the protection seller paying the protection buyer the face value of each debt instrument delivered. The protection seller can then proceed to collect on the debt instrument from the issuer of the debt instrument for an amount referred to as the recovery value of the debt instrument, which has likely been diminished due to the credit event. For example, assume that after a credit event occurs the recovery value of the debt instrument is 70% of its face value (i.e., there is a 70 cents on the dollar recovery rate). The protection seller pays the protection buyer 100 cents on the dollar (i.e., face value of the debt instrument), and the protection buyer physically delivers the debt instrument. The protection seller can then collect the 70 cents on the dollar recovery value from the issuer of the debt instrument or the issuer's successor-in-interest. Alternatively, the protection seller can attempt to sell the debt instrument in the open market.
Cash settlement involves the protection seller paying the difference between the expected recovery value and face value of the debt instrument to the protection buyer. If the protection buyer owns the debt instrument, the protection buyer can then proceed to collect from the debt instrument issuer for the recovery value of the debt instrument. Assuming, that the expected recovery value of the debt instrument is 70% of its face value (i.e., a 70 cents on the dollar recovery rate), the protection seller pays the protection buyer 30 cents on the dollar, and the protection buyer does not hand-over the debt instrument, but instead proceeds to collect the recovery value (i.e., the remaining 70 cents on the dollar if the actual recovery value is equal to the expected recovery value) from the debt issuer or the issuer's successor-in-interest. Alternatively, the protection buyer can attempt to sell the debt instrument in the open market.